Saving money can be extremely difficult. For that reason, you need to be mindful about what you do with the money you’ve saved. Investing your savings can allow it to grow over time.
However, it is important to consider risk when you start to invest. All investments come with risk, but these change according to the type of asset and the organization issuing it. Managing risk can help protect the money you’ve worked so hard to save.
The first step in managing risk is understanding it. Some of the most significant types of investment risks include:
1. Market risk
When you think of the risks involved in investing, you probably think first of market risk. This is the risk that economic developments or other significant events will affect the entire market. Market risk actually involves several different types of more specific issues, however. For example, equity risk is associated with any asset sold in shares. The market price of a share can vary depending on several external factors, as well as supply and demand. If the price drops and you lose money, that is equity risk.
Debt investments like bonds have interest rate risk. You may lose money if the interest rate changes. If the market interest rate increases above what is locked in for the bond, the value of that asset decreases. Finally, market risk also includes currency risk when you invest in foreign assets. As the exchange rate changes, the value of these foreign assets also shifts.
2. Credit risk
Many people think that bonds are low risk. While this is partially true, they do have credit risk. This means that the company or government body issuing the bond can run into financial difficulties and fail to pay interest or repay the principal. Bonds have credit ratings that can help you determine credit risk. Often, government bonds have the lowest credit risk and thus the highest ratings. As a result, government bonds also tend to pay lower interest rates than those from organizations exposed to higher risk. Always look at the credit ratings of organizations issuing bonds to understand the relative risk involved.
3. Concentration risk
Concentration risk occurs when you only invest in one type of asset or specific industry. By concentrating on only one thing, you will be significantly affected if something happens within that industry or asset class. Diversification—spreading your investments across different asset types and industries—can help mitigate concentration risk.
With proper diversification, you can create a portfolio in which some investments are likely to increase in value if others in the portfolio decrease. This balance can help protect your portfolio from big market fluctuations. You may need to work with an experienced financial professional to develop a portfolio that has adequate diversification, or you can invest in assets with built-in diversification, such as mutual funds and exchange-traded funds.
4. Inflation risk
Investors also need to consider how inflation cuts into their returns. Investing money is a great way to hedge against inflation, but there is always the risk that your returns will not keep up with inflation, which means you are essentially losing money. Inflation risk is especially relevant for debt investments like bonds, as well as any cash investments. Equities offer some protection against inflation because companies can increase the amount they charge their customers and thus increase their profits. Thus, share prices tend to increase in line with inflation. Likewise, real estate has some protection against inflation because landlords are able to increase rents over time and thus boost returns.
5. Horizon risk
People generally invest with a specific timeline in mind, which dictates the amount of risk they are willing to accept. If you intend to invest your money over several decades, you can take greater risks, since your portfolio will have more time to recover from losses. However, your investment horizon may be suddenly shortened. For example, you could lose your job and be forced to sell investments before you intended. If the value of the investments is down, you lock into those losses by selling them. Horizon risk is closely related to liquidity risk. Investments are not always liquid as you may need to sell, even at a loss. In some cases, you may not be able to sell at all.
6. Foreign investment risk
One risk of investing in foreign assets has already been discussed. Beyond the risk related to currency exchange, investing in foreign countries comes with other risks, especially emerging markets. Events in these markets can radically affect your investments and perhaps even cause them to lose all value. Before investing in foreign assets, think about the stability of that country and the potential influences on the market. Investing in foreign markets can generate a lot of income, but this is because there are so many different risks at play when you enter them.